In a recent article, I made a reference to the price of Amazon shares reaching a ridiculous 150 forecast earnings. The price of a company is an indicator of the market’s confidence in its abilities to generate cash and return this to shareholders. The higher the P/E ratio is, the more confident that investors generally are that they’ll be getting their money back (and more) in the future. At its most basic, the P/E ratio is the value that shows how much an investor is willing to pay for £1 of that company’s earnings. For example, if the PE ratio was 20, then investors would be paying £20 for every £1 of earnings.
The higher this ratio gets, the more the market believes that earnings will grow in the future. The higher earnings get in the future, then the more money each shareholder will get back, and so the more confident they can be about paying a high price today. Personally, I consider anything approaching a P/E ratio of 20 to be too high for my liking – I prefer to pay low double digits or preferably single digits. Having said this, I know plenty of investors that are willing to buy shares with P/E ratios approach 25 or even 30…but 150…I just can’t believe anyone would be this reckless.
Still, at least Amazon has actually got positive earnings.
What about the madness of Twitter, a company with a PE ratio of nearly 100, although they haven’t managed to grow revenue for over two years and took over 12 years to turn a profit…also losing 1m users at the same time as declaring their first profit earlier in 2018. Or Tesla, a company that has never made a profit, but is currently valued at $45bn? How about Snapchat, another company that’s never made a profit but which investors think is somehow worth $9bn.
These valuations are absolutely insane. I’ve got no other way to describe them. These companies are a black hole for cash and anyone putting their money into them is likely to end up losing a heck of a lot of it in the long-run.
Now please don’t misunderstand me. I am well aware that hundreds of companies take years to turn a profit. They require epic input of time and effort by their founders and start-up teams. But the majority of them also collapse. They’re not a great place to put the bulk of your life savings and yet that is exactly what millions of investors are doing – piling into ‘cool’ sounding start-ups and completely ignoring the fundamentals of the business (which essentially comes down to one thing – turn a profit or collapse).
I’m not the first person to say this and I doubt I’ll be the last, but anyone that’s buying a tracker fund in America right now is also buying a vehicle that tracks growth predominantly created by the growth of these crazy valuations. Until the recent market pullback, the only growth in the American market was in the tech sector – just about everything else was flatlining or shrinking.
When the market wakes up to the fundamental reality of these businesses they have got a long way to fall and anyone that’s holding them through a tracker is just going to fall with them. I can only reinforce my message to wake up and get yourself educated about your finances – don’t sleepwalk into the next crash.